Back To: BUSINESS ENTITIES, CORPORATE GOVERNANCE, & OWNERSHIP

What is Entity Theory?

The entity theory is a fundamental concept assuming that the activities carried out by an organization are separate or distinct from its owners. This theory revolves around the belief that the activities of a business organization are dependent from those of its owners. This covers the concept of limited liability, and the sense of distinction between owning and controlling the company. According to entity theory, owners of a company cannot be held personally liable for its debts and liabilities. Hence, creditors cannot acquire the personal assets or property of the owner for recovering the remaining debt amounts. However, critics find the entity theory irrelevant because of not showing a realistic relationship in the actual business world. Also, it seems to be of no worth for limited liability company (LLC) accounting standards.

How Does Entity Theory Work?

Considering the significance of ownership and control, it is important for business owners to have limited liability in the company. For establishing and following a policy that creates distinction between owners and company, as well as their respective liabilities, the organization sets standards to keep organizational funds separate from those of its owners. The whole business industry in the global markets considers separating the personal and official business operations. Entity theory has a huge role to play in the accounting industry. It is formed on the basis of this following accounting equation: 

Assets = Liabilities + Shareholders Equity 

Here, liabilities is the total of all current liabilities and long-term obligations or debts of the company, while stockholders equity consists of assets that shareholders receive after paying off all liabilities. As per the entity theory, liabilities refer to equities that have distinct legal rights in the organization. Considering the accounting perspective, the entity theory considers company's monetary aspects such as liabilities, assets, incomes, revenues, etc. distinct from the owners personal expenses and money-related operations. Hence, this leads to the separation of identity for owners and managers, and the company itself. For courts, companies are considered to be legal persons, meaning that the company can have ownership of assets, real estate, borrow funds from financial institutions, make agreements, etc. Companies can sue and be sued, and their owners and managerial levels are not personally held liable to the creditors.

Criticism of Entity Theory

The entity theory was founded back then in the 19th century. In spite of being in existence for so many years, the theory has not succeeded much in gaining more recognition worldwide. This is somehow because of the criticism that this theory has received from several researchers. An organization is not independent from its owners, rather it is a source that owners use for reaping profits. Such profits are, in one way or the other, attached to the interests of owners and managerial committee. Their motives are just like the company's stakeholders. This means that owners tend to make investments in the firm with a view to earn returns on them. Besides contributing to a firms capital structure, these investments include efforts, knowledge, hard-work, time, and so on.

Related Topics

• Entity Theory